The holiday season is mostly a time for giving and gluttony, but it can also be a time to reflect on where the markets have been and where they could be going. In joining with the time-honored tradition of providing prognostications for the New Year, I wanted to reflect on where the bond market has been and where it could be going.
On Friday, the 30-year US Treasury bond (a.k.a., the long bond) yield closed at 2.93% and is poised to close the end of the 2012 right on top of where it closed the end of 2011 at 2.895%. I can say with almost absolute certainty that while I don’t know where the long bond yield will close in 2013, I know it won’t be at 2.90%.
Closing unchanged for consecutive years for the long bond -- which is the most volatile US Treasury security -- is an extremely rare occurrence over the past 30 years. In 2001, the long bond closed at a yield of 5.466% after closing 2000 at 5.457%. In 1992, the long bond closed at 7.396% after closing 1991 at 7.40%; in 1988, it closed 8.99% after closing 1987 at 8.978%.
The obvious conclusion for why the long bond yield would be closing the year unchanged is that Federal Reserve policy has been actively holding interest rates artificially low via Operation Twist and quantitative easing. With last week’s FOMC announcement of what is basically an open-ended QE that will be targeting economic “thresholds,” I think the general consensus believes that they will be able to keep these thresholds at these levels. However, upon further examination, it's my belief that market price is saying something different.
I think one of the biggest mistakes investors make when analyzing the bond market from a technical perspective is they get caught up looking the pattern of bond yields -- or worse, the long duration ETF, the TLT. Back on September 10, I addressed this in The Most Important Market No One Is Watching
, when I advised investors to instead focus on the US 30-year bond futures, which I called "the contract."
There are legions of self-proclaimed “macro” strategists and hedge fund managers who cite and trade the bond ETF (TLT). It’s one thing for a retail investor to trade TLT, but there is no self-respecting bond strategist or fund manager that has even ever uttered the letters TLT. Trust me, you will never see CRT’s David Ader cite TLT and you won’t see Paul Tudor Jones trading it. If you want to know what the bond market is doing, you have to watch the contract.
Friday the contract did its thing. Watching the price action pre and post NFP, there was no disputing which way the speculators were leaning, and when they covered on the gap, there was no bid behind. Casual market observers like the New York Times brush off the price action as irrelevant to the story, but I am here to tell you it’s the whole story.
Since the miserable June NFP that only saw 45K jobs added, the contract (Dec now front month) has been confined to a range with the big pivot at 150-00, which is the same level that was tested in Thursday and Friday’s intense volatility. This is not a random coincidence. The market is battling in here.
I have been monitoring the 150-00 level on the US bond contract for months and it has continued to act as the main pivot consolidating the market since the disastrous May NFP number on June 4. Most recently, the 150 level rejected an attempted retrace on December 10, which was the Monday after the November NFP data that saw the contract gap down through it to 149-16. Since then, the long end of the curve has been for sale despite the Fed’s announcement of virtually unlimited Treasury purchases when Operation Twist expires at the end of the year. This past week. the bleeding finally stopped with bond prices finding some oversold support at the psychological 3.0% level on the long bond and the 1.80% level on the 10YR. This week, I want to address two technical developments in the bond contract that focus on this 150-00 pivot level, which will hopefully help guide you in trading for 2013 in both the bond market and likely the stock market as well.
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Since the lows near 115-00 in 2010 that ironically coincided with the end of QE I, the bond contract has been in a very definable rising channel and the center regression line of this channel runs right into the 150-00 level as it ends 2012. This week’s low just above 146-00 also happens to be one standard deviation from this regression line, no doubt helping provide support on both price and relative strength. This lower standard deviation also provided support at the March low earlier this year at the same RSI. The 2011 rally from 120-00 to 145-00 was bracketed by the lower and higher two standard deviations of this regression. For these reasons, I believe this channel will continue to provide support and resistance into 2013, and a break from two standard deviations in either direction should not be faded.
If the Fed Is Controlling the Long End of the Curve, Then Why Is It Trending and Responding to Technical Levels?
Even though the contract has only consolidated the 150-00 pivot over the past six months, it didn’t just appear as the market was making new highs in June. It first showed up in 2009 on the reversal after the blow off top due to the 2008 financial crisis. The 150-00 level is an exact 1.236% Fibonacci ratio extension of the reversal from the 143-00 2008 top to the 113-00 2009 low. This is actually a natural area for the market to target for a number of different technical patterns.
In fact, Fibonacci shows up in many of the pivots, supports, and resistance areas since the 2009 low. The 143-00 level didn’t just mark the 2008 blow off top; it also was an area of intense consolidation in late 2011 and early 2012 as the contract vibrated and twice tested support at the 2010 highs of 136-00, which was another Fibonacci level.
It’s really remarkable that the famed dead Italian could be playing such a prominent role in the price action of a market that is supposedly being manipulated by the Fed. This tells me that the market has structure -- and despite a consensus assumption that the Fed is in control of interest rates, the bond market is not only trending, but is still on a cyclical mission. This big question for investors is whether this cycle is ending or has more room to run. What Are the Levels to Watch for in 2013?
I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it’s very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don’t expect it to go quietly; it will likely put up a tough fight.
On the upside, you obviously have 150-00, which has proven to be a big pivot but also you have to recognize the presence of the dead Italian. If the market can make 150-00 support, there could very well be an attempt to test the upper end of channel. The next Fibonacci stops are the 1.382% at 154-16, the 1.50% to 158-00, and finally, the big 1.682% extension all the way up to 161-16.
What Is the More Likely Scenario?
I give no edge to either move, but I will say that in 2013 I expect a significant shake out in the equity market. I am not looking for a crash, but I think there is more work to be done to the downside in this ongoing bear market, and next year could very well see another leg lower. This is not a hunch but based on credit market metrics that I follow, which are pointing to a material decline in the demand for money; this has historically forecasted a re-pricing of risk premiums. If I am correct, odds would shift toward the bond market testing the upper end of the channel and some of the higher Fibonacci extension levels.
On the flipside, the initial reaction to the latest Fed policy move that I deemed a de facto nominal GDP target
last week has been toward wider inflation premiums and higher yields that have manifested in a steeper curve.
Bernanke has put himself between a rock and a hard place. He can’t come out and say that he wants to reach a nominal GDP number of 19.6 trillion by 2015, or worse, that he needs the growth rate to be 7.0% in order to close the output gap. The bond market would crash. But the market is not stupid. The longer he attempts to hold bond yields below the rate of inflation while at the same time trying to stimulate the inflation that erodes these same coupons, the more worthless they become and the more interest rate risk he generates. It seems at some point Bernanke will be facing a Pyrrhic victory. If he is successful, eventually the curve will unwind and the bond market will crash.
If the Fed is successful in reflating the economy in 2013, the Pyrrhic victory could be a real scenario and if it gets traction the market could be under significant pressure and the lower objectives would be in play. Because of the technical nature of the rising channel and important 143-00 level I think on balance there is less margin for error and thus more risk on the downside.
Nevertheless, this is the time to leave your bias at the door. The bond market has been consolidating a relatively tight range for six months and has lulled many participants to sleep. I think this thing is wound up and ready to break out. It’s unlikely that we will be sitting in this same spot next year; which way we go and where we end up is going to have wide-ranging ramifications for the asset markets and implications for the economy.